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April 29, 2024
To the friends and clients of the Harvey Investment Company:
Despite sticky inflation data, indications of a weakening economy, and concerns that the Fed will hold interest rates higher for longer, U.S. equity markets started off the first quarter (“Q1”) on a positive note. The S&P 500 Index advanced 10.5% through the end of March. We’ve commented over the last few quarters about the narrowness of the advance in stocks. This narrative continued to hold true during Q1. By our math, the top 5 contributors in the Index accounted for almost 50% of the Index’s total Q1 return. The gains from these contributors were powered by strong financial results and exposure to the themes du jour – cloud computing, artificial intelligence and weight loss drugs. To be sure these businesses have unique advantages and attractive growth prospects, but it’s fair to wonder if there is a mismatch between the high valuations these businesses carry relative to the growth that you should expect from them. As the wise Warren Buffett once said, “the future is never clear, you pay a very high price in the stock market for a cheery consensus.”
The calendar has almost flipped to May, and like every year, the city of Louisville is focused on the Kentucky Derby. Most everyone in the city will be at the track or distracted by how they’re going to pick the winner in this year’s race. Should you pick the horse with the fun name? Maybe the horse with the proven pedigree that sold at auction for millions of dollars? What about the overlooked horse that quietly comes into Churchill Downs with surging workouts? Or maybe you should follow the hot money by watching the tote board, picking the horse where the odds have moved the most right before post time? There’s a myriad of ways to decide and candidly, I was so lost about who to pick this year that I pulled out a copy of The Winning Horseplayer by legendary handicapper Andrew Beyer in search of answers. I came across a story in the book about Fusaichi Pegasus (“Fu Peg”) that interestingly enough seemed to share a lot of similarities with the current stock market. It is a cautionary tale about dealing in generalities and what can happen when you overpay.
Fu Peg’s sire was Mr. Prospector, the most successful stallion in Triple Crown race history. Almost 45% of Triple Crown race winners have some lineage to Mr. Prospector. It wasn’t just Fu Peg’s pedigree that wowed interested bidders at his auction. At the 1998 Keeneland yearling sale Fu Peg was said to be charismatic, smart, big and moved effortlessly. By all accounts, Fu Peg had all the right stuff. So much so, that he broke a thirteen-year-old record for the most expensive yearling sale at a price of $4,000,000. After losing his first race, he reeled off three wins in a row and Fu Peg entered the 2000 Kentucky Derby as a 2-to-1 favorite.
In a game of uncertainty, Fu Peg was as close to a sure thing as you could find. And he delivered. In the 2000 Derby, Fu Peg rallied from fifteenth place to close from far out and win. A fast early pace set up a perfect trip for a closing horse such as Fu Peg. Fu Peg saved ground on both turns before angling out and bolting past the tired leaders. It was the first time a favorite had won since 1979. He was heralded as a super-horse.
Few people took a skeptical view of his performance, but one who did was Andrew Beyer. Fu Peg ended the race with what looked to be an impressive speed figure of 108, a data point that handicappers use to rate the performance of race horses. However, if you looked closer, like Beyer, you would have seen the speed figure had much more to do with Fu Peg’s perfect trip than his natural talent. Fu Peg was so hyped after his Derby performance that he entered the Preakness Stakes as a 3-to-10 favorite before ultimately losing in an upset bid to 6-to-1 Red Bullet. He continued to be hyped throughout the rest of the year until he was soundly beaten and finished 6th place in the Breeder’s Cup Classic.
Fu Peg fell from super-horse status to just another talented horse. He ended his racing career winning six races in nine starts with career earnings of $1,994,400. The biggest losers in the Fu Peg saga were likely the buyers of Fu Peg’s breeding rights which were sold for a record $72,000,000 shortly after his Kentucky Derby win. Due to the disappointment of his offspring’s racing success, Fu Peg’s stud fee was cut in half by year 6 and for his last eight years of breeding his stud fee was a paltry $7,500 – a far cry from his beginning fee of $150,000 in year 1. It’s unlikely the $72,000,000 was ever recouped.
Yogi Berra famously said, “you can observe a lot just by watching.” A closer examination of Fu Peg’s Derby run likely would have led you to the conclusion that he was not a smart bet at 3-to-10 in the 2000 Preakness. The same can be said about several of the current popular stocks propping up the Index. Like Fu Peg, many of the buzzy technology-related market leaders are quality businesses and their valuations very much reflect that. Therein lies the problem. Many feel that there’s no need to scrutinize a business as long as the stock price is going up. It’s hard to see what’s wrong when you’re wearing rose colored glasses. Look a little deeper and you might find that some of today’s high-flying stocks are in fact not super-horses, merely talented horses that might just be overvalued.
In today’s market, quality has become a momentum trade. Buy the quality stocks whose prices are rising, rinse and repeat. Simple as that, right? Not so fast. History has told us that favor and disfavor in the market has a tendency to reach extremes. Things change. Dominance is not a guarantee and ultimately what you pay will determine your success. You can still lose money picking good businesses (or good horses) if you overpay.
Investors must review businesses with an open mind, drawing conclusions rooted in specifics, not generalities. At Harvey Investment, we want to be grounded in facts. We want to find businesses that have basic value that we understand. If they’re out of fashion and selling at a discount, even better.
We hope you have a great Derby Week and know how much we appreciate your support. Give us a call with any questions.
Sincerely,
Hunter Noble
Every year, we file an annual update amendment to our Form ADV with the Securities and Exchange Commission, our chief regulator. This disclosure document contains information about the business practices and procedures of Harvey Investment Company, LLC. There was one “Material Change” in our business to report in this year’s amendment. Will West was removed as a portfolio manager. We are pleased to offer you upon request and without charge a copy of Part 2A of our Form ADV. This document is available through our website (www.harveyinvestment.com) in the “Legal and Regulatory Disclosures” section or you can call us at (502) 339-8270, if you would like a copy.